The Employment Effect of Subsidies

Report to the Directorate General Employment
, Industrial Relations and Social Affairs

Commission of the European Communities

SOC 94 100018 05A01

J K Swales*D R Holden†G Beacon‡

November 1995

* Fraser of Allander Institute and Department of Economics, University of Strathclyde
† Department of Economics, University of Strathclyde
‡ Beacon Dodsworth Ltd

EXECUTIVE SUMMARY

High levels of unemployment, particularly amongst unskilled groups, is a
serious structural problem for many European countries. In this report we build on
previous work by Jackman and Layard, Johnson and Beacon and Monk to investigate
the effectiveness of general labour subsidies in tackling this problem. We find that
the government can influence long-run employment levels by introducing an
appropriate tax and subsidy system, even where the economy is working in a perfectly
competitive way.

The specific policy package which we considered in detail involves the
introduction of a fixed per capita labour subsidy, equal to 5% of the average wage,
financed by an increase in VAT. The tax/subsidy scheme works by allowing for some
substitution of capital for labour, but more generally by pricing workers into jobs
through subsidisation and increasing the incentive to work, especially amongst lower
paid workers. Estimates are made of the output and dissagregated employment
effects under various assumptions about the capital market and the nature of labour
supply. Total employment and total output always increase. The proportionate
expansion in total output lies within the range 0.8% and 2.8% and the increase in
employment in the range 1.45% to 4.0%. Low paid sectors of the labour force are
stimulated the most so the policy has favourable distributional aspects. The existance
of savings on unemployment benefits acts to reinforce employment effects.

Governments are generally concerned about the overall level of taxation
within the economy and therefore question the desirability of automatic subsidy
programmes. However, the type of subsidy and tax plan that we outline could, in
principle, be operated as an integrated tax scheme in which the change in the firm's
tax bill is calculated as the net difference between the additional VAT and the per
capita subsidy. In so far as the scheme increases total employment, and thereby
reduces payments of unemployment benefit, it would be associated with a reduction
in the overall tax rate. That is to say, the introduction of a new tax scheme would
simultaneously increase employment and reduce taxation.

There is at present an increased faith in "market forces" and a general desire to
reduce subsidies that artificially maintain inefficient or inappropriate industries.
However, where there are high levels of structural employment amongst primarily
low skilled workers, and where these unemployed are supported by welfare payments
which lower the real income of workers and reduce their incentive to work, the
possibility of long-term labour subsidies should be considered. Such subsidies
improve, rather than impair, productive efficiency by offsetting market failures in
other parts of the economy. They restore, rather than distort, appropriate price
signals. They do not rob the private sector of resources but reallocate resources
within that sector. As we have seen, such subsidies generate an expansion, not
contraction, of private sector economic activity. Further if such subsidies can be
packaged as tax rebates the possibility occurs of a simultaneous fall in taxation and
increase in employment.

1 INTRODUCTION

High levels of unemployment, particularly amongst unskilled groups, is a serious
structural problem for many European countries. In this report we make a theoretical
investigation of the use of labour subsidies to tackle this problem. In Section 2 we
review previous work in this area. In Section 3 we outline a simple general equilibrium
model for identifying the impacts of a labour subsidy, give a specific form of the model
which can be used for simulation purposes and then report the results of some illustrative
simulations. Attention is drawn in this section to the balanced budget requirement for the
financing of such a subsidy and the interaction with the unemployment benefit system.
In Section 4 we discuss the appropriateness of the model for investigating this problem.
In Section 5, we consider political issues.. Section 6 is a short conclusion.

2 REVIEW OF EXISTING MODELS

In two articles in Economica, Jackman and Layard (1980) and Johnson (1980)
argue for government intervention in the labour market in order to reduce total
unemployment. One of the policies that they consider is a subsidy on employment for
particular segments of the labour market. Whilst these articles are rather abstract and
technical, they have a number of important strengths. These are that

They explicitly consider neo-classical models.
That is to say, systems in which competitive product markets clear.
When labour-market distortions are investigated, they are of the most
straightforward type. The most common is the existence of unemployment benefit,
which might reduce the labour supply for some low-wage groups.
However, both papers also deal with cases where there is a degree of wage rigidity,
either in the form of minimum wages or fixed wage differentials.

They adopt a general, rather than partial, equilibrium approach.

They impose a neutral budget condition so that the financing of any subsidies
must be made explicit.

Even though both papers adopt rather sparse models, which are solved analytically,
the solutions that they adduce are quite complex.

2.1 Jackman and Layard (1980)

Their basic model has the following characteristics:

There is only one commodity which is produced from two inputs only.
These are different types of labour, which the authors label "skilled" and "unskilled".

The production function is linear homogeneous.

The output is sold and labour is bought in perfectly competitive markets.

The supply of each labour type is an increasing function of the real take-home wage.

There is no international trade.

Government expenditure on public goods is fixed.

Initially the PSBR is zero, with taxes on labour income covering expenditure on
public goods and unemployment benefit.

This model is used to analyse the impact on total employment, output and welfare of
two labour tax and subsidy schemes.

First, the authors consider a "self-financing" tax and subsidy regime where one
group of workers is taxed and the other subsidised and the total value of the taxes on
one group just equals the total value of the subsidies on the other labour group.
The results here are very straightforward. If group 1 is taxed and group 2 subsidised,
total output, employment and welfare will rise as long as

respectively, where:

i is the labour supply elasticity of group i with respect to the
relevant gross wage,

Wi is the gross wage of an individual in group i, and

mi is the labour market distortion which is defined as

where ti is the average tax rate payed by workers in group i
and Bi is the unemployment benefit which such a worker would qualify for.

Although the schemes here are called "self-financing", this is a little misleading.
In general such a scheme will lead to an increase in employment in unskilled (type 2)
labour and a reduction in employment in skilled (type 1) labour. There will therefore be
foregone taxation on the income from newly unemployed skilled workers and increased
unemployment benefit payments to these workers. On the other hand, there will be increased
tax receipts from newly employed unskilled workers and a reduction in the benefit payments
for this group.

These changes will have effects on the overall public sector budget which will lead
to variations in the general taxation levied to meet the financing of public goods
(whose provision is assumed constant) and unemployment benefit. Jackman and Layard take
these general taxes to be levied at a constant rate on (wage) income, so that changing the
general level of taxation implies varying this tax rate. Clearly it could be the case, on
the criteria above, that the introduction of the "self-financing" tax-subsidy regime will
lead to an increase in employment whilst generating a public sector deficit. This would
occur if the increase in employment were modest and there was a big difference in the
average wage and the unemployment benefits paid to the two groups, the levels of both being
assumed to be higher for skilled than unskilled workers. Such an increase in general
taxation would reduce the net returns from work, decrease the supply of both types of
labour and thereby reduce employment. Such reductions would partly, and might wholly,
offset any gains predicted from the earlier analysis.

However, Jackman and Layard show that where there are positive welfare gains from
the introduction of the "self-financing" subsidy, the public sector finances will improve
also. Under these circumstances, the introduction of the self-financing tax-subsidy scheme
will allow a reduction in general taxation, which will generate further increases in
employment. We therefore concentrate on the conditions both for an increase in
"self-financing" employment and welfare. Therefore from the analysis presented in this
paper a sufficient condition for employment to increase is

We would normally assume that the wages of unskilled workers are lower that skilled
(W1 > W2) and that the distortion in the labour market caused by
taxation and unemployment benefit is higher for lower waged workers (m2 >
m1), this implies

so that a sufficient requirement for employment to unambiguously increase is simply that
the elasticity of labour supply is greater for unskilled labour than skilled labour.

Note that this condition also ensures that economic welfare will rise and that there
will be a more even distribution of income as employment and wage rates for unskilled
workers will rise, as against skilled workers.

Although Jackman and Layard are primarily concerned with a situation in which the
wage rates for both types of labour are flexible, they do also analyse the case where
there is some wage rigidity. In particular, they consider a set up where there are a
set of rigid wage differentials. Specifically:

the relative gross pay of skilled to unskilled workers is fixed.

skilled workers are on their labour supply curve but there is excess supply of
unskilled workers at the relevant wage, so that the unskilled labour supply curve
is suspended.

Under these conditions the potential benefits from wage subsidies, financed by a
tax on employers for each skilled worker, generates an even greater welfare gain.

2.2 Johnson

Johnson is concerned with a very similar analytical framework to that adopted by
Jackman and Layard. However, his work differs in a number of important respects.

There are an undetermined number of inputs (n).

Two are not fully employed, youth labour and unskilled labour.

The causes of unemployment in these two sectors of the labour market are as follows.
In the youth market, there is some form of minimum real wage which prohibits labour market
clearing. In the market for unskilled labour, a similar sort of arrangement might occur
or the presence of unemployment benefit might reduce effective labour supply below the
registered labour force.

All other inputs are taken to be in fixed (totally inelastic) supply and their price set
at the market clearing level.

A central concern is the distribution of costs and benefits between different factor owners.

In Johnson's analysis, ad valorem subsidies are paid at different rates to
employers of youth and unskilled workers. These subsidies, together with all government
expenditure on public goods, are financed by a proportionate tax on all other factor inputs.
That is to say, it is assumed that youths and unskilled workers pay no tax, so that the
burden of all government expenditure is borne by the other factors of production.

The impact of the subsidies on total employment depends solely on their impact on
the two "target" groups. This is because the supply of all other factors is fixed and
their market price is set at their market clearing rate. The effect of a subsidy on one
labour group is always to increase the employment of that group. Therefore if there is
only a subsidy on youths, youth employment will rise. However, the effect on the other
group suffering unemployment (in this case, unskilled workers) is ambiguous and depends on
whether they are complements or substitutes for the subsidised group. If they are
complements, the employment of the unsubsidised labour group will rise: if they are
substitutes it will fall. Three points are important here.

Where both labour groups are subsidised, the effect of their own subsidy on their own
employment is positive.

Conventional production functions have inputs as complements: the productivity of one
input rises as the supply of a second input rises. In this case, the subsidy on one input
increases the demand for the second subsidised input.

Even where the two inputs are substitutes, the negative cross-effect between the two
inputs have to dominate the own effects if employment is not to rise.

The employment effects identified by Johnson are rather more complex than those in
Jackman and Layard. The reason is that he allows the factors to be substitutes, whereas
in a two-factor well-behaved production function, inputs must be complements. However,
Johnson's main interest is in the effect of the subsidy on the gross and net-of-tax
earnings of the other factor owners. His argument is essentially that if the income of
one group is adversely effected by a subsidy, that group might mobilise to block such a
subsidy.

If we start with the introduction of subsidies where the wages of both youths and
the unskilled are fixed in real terms (by minimum-wage legislation, for example), the gross
earnings of the other n-2 factor owners are increased by the amount spent on the subsidies.
Moreover, if the employment of unskilled workers is increased, expenditure on unemployment
benefit for that group is reduced. (Youths are assumed not to qualify for unemployment
benefit). This implies that for taxpayers as a whole, net after-tax income rises.
As Johnson remarks, this implies that if the target labour groups have inflexible wages
set too high to clear their segments of the labour market, subsidies are an excellent deal
for taxpayers as a whole. One caveat here is that whilst taxpayers in general benefit,
the after-tax income of certain groups of factor owners might fall, if their factors are
substitutes for the subsidised labour.

In the more complex case, the youth labour market again has a fixed real wage, but
the labour market for unskilled workers clears.1 However, this does not mean
that there is no unskilled unemployment. In this segment of the labour market, the
position is similar to that analysed in Jackman and Layard: the supply of unskilled labour
is not perfectly inelastic, and there is a gap between the level of employment and the
number of unskilled workers registered for employment. Changes in the demand for unskilled
workers will therefore effect both the wage and employment of unskilled workers.

Under these conditions, the subsidy programme for low-skilled adults increases the
post-tax income of taxpayers as a whole as long as

where e is the elasticity of supply of unskilled workers and r is the replacement ratio
in the unskilled labour market, that is the ratio of the unemployment benefit to the
unskilled wage. Where this condition holds, the youth subsidy will increase the taxpayer's
real income as long as youth and unskilled employment are complements. Finally, it is
important to state that even where other taxpayers are made worse off by the introduction
of labour subsidies for some labour groups, that does not necessarily imply that there are
not welfare gains to such subsidies.

Whilst these two papers are rather abstract, they are important in that they show:

In a long-run equilibrium perfectly-competitive system, a self-financing tax-subsidy regime
can generally increase employment. This has nothing to do with traditional Keynesian
macroeconomic influences, non-governmentally induced labour market imperfections or
terms-of-trade effects.

Where the government pays unemployment benefit, there are straightforward conditions
under which the introduction of a subsidy will increase economic welfare, even where
economic welfare is defined in a very conventional (and conservative) manner. That is to
say, we need not take into consideration issues such as a link between unemployment and
ill health, crime or other forms of social breakdown, for this argument to go through.
This is not, of course, to assert that these social issues are unimportant. Howeverr,
the UK, at least, seems extremely reluctant to accept any evidence of a relationship
between these forms of social problems and unemployment.

Where the government pays unemployment benefit, there are clear conditions under
which a subsidy will increase the post-tax income of the average owners of non-subsidised
factors. These conditions are not arcane of extreme. Moreover, the notion of income here
is the straightforward one of command over goods and takes no account of any real increase
in welfare that employed workers of one type may gain from reducing the level of
unemployment in other sectors of the labour market, or their own risk of becoming
unemployed.

These arguments are important to counter views that labour market intervention
reduces employment and welfare and that the issues involved in such policies are the
familiar efficiency versus equity ones. Such erroneous views are expressed by the UK
Government in HM Treasury (1991, p. 70) in its discussion of the rules to be used in the
evaluation of industrial and regional assistance whose central goal is job creation.
"Because of crowding out at the macroeconomic level, effects on employment ... should not
be included as benefits of projects in an efficiency test." As has been demonstrated by
Jackman and Layard (1980) and Johnson (1980), such "crowding out" would not, in general,
be expected to occur.

2.3 Beacon and Monk

The work of Jackman and Layard (1980) and Johnson (1980) is purely analytical and
each concentrate on two types of labour. In the case of Jackman and Layard, there are only
two productive inputs, skilled and unskilled labour: for Johnson, there are n inputs but
all but two, youth and low skilled adults, are in completely inelastic supply. Beacon and
Monk (1987) approach the problem in a more flexible manner. Their analysis is similar to
those of Jackman and Layard (1980) and Johnson (1980) in that they employ a closed-economy,
one-sector model and the subsidies investigated are fully funded so that the public sector
budget is always balanced. However, their model differs in the following characteristics:

There are six factor of production, capital and five separate labour categories.

The supply of each factor input is sensitive to the factor's price. That is to say,
no factor has a completely inelastic supply.

The model is concerned with aggregate unemployment, not simply unemployment within one
or two employment groups.

This is a numerical model where the results are derived by computer simulation.

Beacon and Monk (1987) simulate the impact of a fixed per capita labour
subsidy financed by an increase in VAT. They argue that one would expect that such a
subsidy would have two important effects.

A substitution of labour for capital.

A substitution of lower paid workers for higher paid workers. This effect applies
because the proportionate impact of a fixed subsidy is greater where the original wage is
lowest. This is seen as important because unemployment is regarded as being a problem
primarily for lower paid workers. According to Beacon and Monk, this is because the wages
of lower-paid workers are close to the unemployment benefit level, and such workers are,
in essence, likely to be "voluntarily" unemployed.

If such substitution effects increase the level of employment, and thereby reduce
unemployment, then the employment impact will be further amplified by the downward
adjustment which can be made to the VAT rate because government expenditure on unemployment
benefit will have fallen.

Because of the differential impact of the fixed per capita subsidy on labour
groups with different wages, Beacon and Monk (1987) separate the labour force by wage level.
That is to say, the five groups identified in their analysis are simply the five quintiles
of the labour force ranked by wage. It is assumed that workers in a given quintile earn
the same wage. It is also assumed that workers in different quintiles will have different
labour supply characteristics. In particular, the lower the wage, the higher the wage
elasticity of supply.

The simulations that Beacon and Monk perform are stylised and indicative.
For a fixed per capita labour subsidy equal to 20% of the average wage, there
is an increase in total employment of 3.5%. Employment in all segments of the labour
market rises, by a maximum of 9.6% in the lowest wage quintile to 0.03% in the highest
wage quintile. Capital employment falls by 5.9%. In these simulations all workers
benefit, in the form of increased employment and wages and there is a reduction in the
payment of unemployment benefit. Owners of capital loose.

The work of Beacon and Monk (1987) in some respects extends the earlier analytical
models of Jackman and Layard (1980) and Johnson (1980), but it has a couple of drawbacks.
First, it seems to imply a fixed output, so that all the effects come through substitution.
From the earlier work, we know that there will be output effects too, which are likely to
increase the positive employment impact identified in the simulations. Second, the
treatment of capital is rather cavalier. This would be less important were it not the
case that the role of capital is crucial in their simulations. Capital is the only factor
whose real payments fall as the result of the introduction of the subsidy scheme; both the
use of capital and its real return decline, though Beacon and Monk (1987) do not comment
on the economic or political implications of these reductions. Moreover, if capital were
to be treated differently, it might be that conflict would occur between labour groups.
In particular, in their reported simulations, high wage groups experience a very small
gain in real income from the labour subsidy. However, such high wage groups might be
faced with lower employment and real wages if the supply of capital were more elastic.